CH 3

CHAPTER T H R E E
3 International Economics
Twelfth Edition
The Standard Theory

Of International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Learning Goals:
 Understand how relative commodity prices and

the comparative advantage of nations are
determined under increasing costs.
 Show the basis and the gains from trade under
increasing costs.
 Explain the relationship between international
trade and deindustrialization in the U.S. and
other advanced nations.
3.1 Introduction
 Extending the simple trade model

 Increasing opportunity costs
 Tastes and preferences
 Incomplete specialization
3.2 The Production Frontier with Increasing
Costs
Increasing Opportunity Costs

 A nation must give up more and more of one
commodity to release just enough resources to
produce each additional unit of another commodity.
 Increasing cost production possibilities frontier is
concave to the origin.
 The marginal rate of transformation (MRT) increases
as more units of good X are produced.
 The marginal rate of transformation is another name
for opportunity cost.
 The value of MRT is given by the slope of the PPF.
FIGURE 3-1 Production Frontiers of Nation 1 and Nation 2 with
Increasing Costs.
3.2 The Production Frontier with Increasing
Costs
Reasons for Increasing Opportunity Cost and

Differing PPFs
 Factors of production are not homogeneous, and thus

producing increasing amounts of a good requires
using inputs that are less productive.
 Different countries have different resource
endowments, giving rise to different PPFs.
 May also use different technologies.
3.3 Community Indifference Curves
 Combinations of two commodities that yield

equal satisfaction to the community or nation.
 Negatively sloped and convex to the origin.
 Cannot cross.
 Slope = Marginal Rate of Substitution (MRS)
 The MRS of X for Y in consumption is the amount
of Y that a nation could give up for one extra unit
of X and still remain on the same indifference curve.
 The marginal rate of substitution (MRS) falls
as more of good X is consumed.
FIGURE 3-2 Community Indifference Curves for Nation 1 and
Nation 2.
3.3 Community Indifference Curves
 Problems
 The distribution of income is held constant when
drawing community indifference curves, and a
different income distribution could result in very
different curves.
 Trade can change the distribution of income
significantly, and thus expansion of trade may cause
intersecting indifference curves and unclear effects on
social welfare.
 Compensation principle: the nation benefits from trade if the
winners would be better off even after compensating the
losers.
3.4 Equilibrium in Isolation
 Interaction of forces of demand (community

indifference curves) and supply (production
possibilities frontier) determine equilibrium for a
nation in the absence of trade (autarky).
 Nations seek the highest possible indifference curve,
given the production constraint.
 The equilibrium-relative commodity price in isolation
= slope of tangency between PPF and indifference
curve at autarky point of production and consumption.
 Relative prices are different in Nation 1 and Nation 2
because of different shape and location of PPF’s and
indifference curves.
FIGURE 3-3 Equilibrium in Isolation.
3.5 The Basis for and Gains from Trade with
Increasing Costs
 Relative commodity price differentials between

two nations reflect comparative advantages, and
form basis for mutually beneficial trade.
 Each nation should specialize in the commodity they
can produce at the lowest relative price.
 Specialization will continue until relative prices
equalize between nations.
 Specialization will usually be incomplete, since costs
of production increase in each country with greater
specialization.
FIGURE 3-4 The Gains from Trade with Increasing Costs.
Increasing Costs
 Equilibrium-relative commodity price with trade =

common relative price at which trade is balanced.
 Balanced trade: quantity of X (Y) Nation 1(2) wants to
export = quantity of X(Y) Nation 2(1) wants to import.
 Any other relative price could not persist because trade
would be not be balanced.
 In general, the greater the change from a nation’s
autarky price to the post-trade price, the greater the
size of the gains from trade.
Increasing Costs
The Gains from Exchange and Specialization

 A nation’s gains from trade can be broken down into
two components.
 Gains from exchange = increase in consumption from
the change in the relative price (compared to the
autarky price), holding production constant. (Point T
in Figure 3-5)
 Gains from specialization = increase in consumption
resulting from the reallocation of production towards
the good in which the country has a comparative
advantage, holding the world relative price constant.
(Point E in Figure 3-5).
Increasing Costs
 The switch in production of goods from autarky

to the trade equilibrium also causes changes in
employment of factors of production in each
sector.
 In industrialized countries, this implies loss of
manufacturing jobs– deindustrialization.
 But empirical evidence shows that most
manufacturing job loss has been due to change in
labor productivity and other internal causes rather
than trade.
Case Study 3-1 Comparative Advantage of the
Largest Advanced and Emerging Economies
Case Study 3-2 Specialization and Export
Concentration in Selected Countries
Case Study 3-3 Job Losses in High Import-
Competing Industries
Case Study 3-4 International Trade and
Deindustrialization in the United States, the
European Union, and Japan
Case Study 3-4 International Trade and
Deindustrialization in the United States, the
European Union, and Japan

CH 3

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CH 3

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CHAPTER T H R E E

The Standard Theory

 Understand how relative commodity prices and

 Extending the simple trade model

Increasing Opportunity Costs

Reasons for Increasing Opportunity Cost and

 Factors of production are not homogeneous, and thus

 Combinations of two commodities that yield

 Interaction of forces of demand (community

 Relative commodity price differentials between

 Equilibrium-relative commodity price with trade =

The Gains from Exchange and Specialization

 The switch in production of goods from autarky

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